posted on 22 January 2017
by Lance Roberts, Clarity Financial
Since the November election of Donald Trump, the investing landscape has gone through a dramatic change of expectations with respect to economic growth, market valuations and particularly inflation. It is the view of inflation that I want to touch on today as it relates to the belief the "Death Of Great Bond Bull Market" has finally arrived.
The chart below shows the massive surge in inflationary expectations as of late in both the 5-year and 10-year rates as well as the mean PCE inflation rate. (#SarcasmAlert)
As you can see, while expectations of a rise in inflationary pressures have risen since the election, the consumer price index (CPI) was already rising fairly strongly since the beginning of 2015.
So, if the rise in inflation expectations remains muted, what's the reason for the recent surge CPI? That rise can be directly linked to the full onset of the Affordable Health Care Act which sent medical inflation costs surging. This is something I warned about many times in the past.
The Fed believes the rise in inflationary pressures is directly related to an increase in economic strength. However, as I will explain: Inflation can be both good and bad.
Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports. Such increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allowing for absorption of higher prices.
That would be the good.
The bad would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.
If we take a look at import and export prices there is little indication that inflationary pressures are present.
This lack of economic acceleration can be seen in the breakdown of the Consumer Price Index below. It can clearly be seen where inflationary pressures have risen over the last 5-months.
(Thank you to Doug Short for help with the design)
As is clearly evident, the surge in "health care" related costs, due to the surging premiums of insurance due to the "Un-affordable Care Act," pushed both consumer-related spending measures and inflationary pressures higher. Unfortunately, higher health care premiums do not provide a boost to production but drain consumptive spending capabilities. Housing costs, a very large portion of overall CPI, is also boosting inflationary pressures. But like "health care" costs, rising housing costs and rental rates also suppress consumptive spending ability.
The problem for the Fed is that by pushing interest rates higher, under the belief there is a broad increase in inflation, the suppression of demand will only be exacerbated as the costs of variable rate interest payments also rise.
With households already ramping up debt just to make ends meet, another increased expense will only serve to further suppress "consumer demand."
The Rest Of The Story
By narrowly focusing on consumption, economists have lost sight of production. Such disregard for the supply curve is proving to be a costly error.
As monetary policy increasingly encouraged debt-financed consumption, corporations responded by expanding their capacity and operations to keep up with the policy-induced demand for their goods. Both the demand and supply curves shifted in unison, reflecting greater demand and production capacity. Unfortunately, over time, the consumers' ability to take on additional debt has diminished and the demand curve shifted back. The supply curve, however, is less flexible as corporations cannot easily reduce their production capacity. Attesting to this overbuild is capacity utilization which, as graphed below, is trending lower and stands at a level that has been indicative of recessions in prior cycles.
Data Courtesy: St. Louis Federal Reserve (FRED)
In response to weaker demand, corporations downsized employment, outsourced production and limited wage increases. Partially as a result of their actions, the labor participation rate lingers at 38 year lows and real median wages are at levels comparable to 1998. Corporations created a negative economic feedback loop as their employees are also consumers of their products.
Another unfortunate consequence of weaker demand is that instead of investing some profits towards productive activities, a majority of corporate cash flows have been diverted to shareholders to engineer better financial ratios and earnings per share to help compensate for weakening sales. The results may be optically appealing and supportive of equity market valuations in the short-term, but these decisions are decidedly not constructive for the long term health of the corporations and the economy.
The bottom line is that disregard for production oriented aspects of the economy (the supply side) and myopic over-emphasis on debt-financed consumption (the demand side) naturally limited potential corporate and national economic growth.
So...What's Driving Rates?
Here's the short answer:
Let me explain.
There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to last year. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (You have to kind of squint to see it.)
While the bump in rates has been fastened to the recent election of Donald Trump, due to hopes of a deficit expansion program (read: more debt) and infrastructure spending which should foster economic growth and inflation, it doesn't explain the global selling of U.S. Treasuries.
For that answer, we only need to look at one country - China.
It is important to understand that foreign countries "sanitize" transactions with the U.S. by buying treasuries to keep currency exchange rates stable. As of late, China has been dumping U.S Treasuries and converting the proceeds back into Yuan in an attempt to stop the current decline.
The stronger dollar and weaker yuan increase the costs of imports into China from the U.S. which negatively impacts their economy. This relationship between the currency exchange rate and U.S. Treasuries is shown below. (The exchange rate is inverted for illustrative purposes.)
The selling of Treasuries by China has been the primary culprit in the spike in interest rates in recent months. As I will discuss in a moment with respect to the trade deficit, there is little evidence of a sustainable rise in inflationary pressures. The current push has come from a temporary restocking cycle following a very weak first half of the year economically speaking, and pressures from higher oil, health care, and rental prices.
As noted by Horseman Capital in their recent note to investors (Via Zerohedge):
This is shown, the annual rate of change in U.S. bond holdings by China is rapidly approaching historical lows (axis is inverted).
While much of the mainstream media continues to protest the "Great Bond Bull Is Dead," as expectations rise for a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then population, wage and consumer debt growth become key inputs into that equation. Unfortunately, with wage growth stagnant and on the decline, population growth weak and consumers already extremely leveraged, a surge in economic growth to sustain higher interest rates is highly unlikely.
The Tailwind For Bonds
As explained, my case for interest rates is lower rather than higher. China's selling will eventually abate as either they run out of Treasuries to sell or they stem the tide of the currency decline. Furthermore, economic weakness will likely reassert itself this year as a recessionary spat approaches pushing rates lower.
Regardless of which occurs first, the setup for a push towards 1% on the 10-year Treasury, or lower, is already baked into the cake. As my friend Dana Lyons pointed out this past week:
If the market corrects, OR the economy hits a speed bump, OR something happens in the Eurozone, OR...OR...OR...the covering of short positions in bonds will cause an extremely fast drop in yields.
Sure, anything can happen. If yields on the 10-year Treasury break above 3% it will be coincident with a sharp rise in consumer spending, wages, inflationary pressures that are broad based and surging economic growth. In such a case it will make sense to reduce bond holdings in favor of equities.
However, given the fact we are already in the 3rd longest economic expansion in history, combined with the second highest levels of valuation on stocks, the odds of such an outcome are extremely low.
I remain long bonds as a hedge against my long equity exposure.
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